Individual and corporate savers: It's time to pay more attention to where you invest your cash.
The Federal Reserve Bank's decision yesterday to raise interest rates this week, for the third time in the last 15 months, is good news for savers tired of earning next to nothing on their cash balances. But getting the return you deserve will require extra work.
When it comes to deposits and savings accounts, financial institutions are well known for responding slowly to rising interest rates. When the Fed is lowering the Fed Funds rate, banks and brokerage firms and money market funds are quick to do the same, often in lockstep with the central bank -- basis point for basis point. By when the tightening cycle begins (as now appears to be the case), rates paid to investors tend to be "sticky" -- an industry term of art meaning "slow to go up."
What once went down will eventually go up... just not as fast.
Ever since the financial crisis, corporations and individuals with cash to invest have been getting paid anywhere from .01% (virtually nothing) to .50%, even though inflation has been running 1.5% to 2.0% a year. This state of affairs -- negative real rates of return on cash for extended periods of time -- is known as "financial repression." Essentially, it means that central banks have been supporting the economy on the backs of short-term savers.
But financial institutions also find it hard to make money when interest rates are low. That's because the spread between what they pay for cash deposits and what they get paid on loans, known as the "net interest income," gets compressed.
That's true for bank and it's true for brokerage and wealth management firms and it's true for money market funds.
Rising interest rates present a long-awaited opportunity for financial institutions to increase spread income. How? By raising rates more slowly than the Fed.
What that means is that there is likely to be a wider dispersion between the rates different institutions pay on cash in a rising rate environment than there has been for many years. Investors who pay attention will be rewarded.
Safety First... But Comparison Shop
The first rule of investing cash is always: safety of principal. The second rule is: read the first rule. But the third rule is: comparison shop. Even across instruments of similar quality, opportunities exist to pick up additional yield.
Insured Certificates of Deposit
The biggest differentials tend to exist at financial institutions that set the rates they pay for cash. "FDIC-insured certificates of deposit (issued by banks) are a no-brainer," one cash manager told me. Go online to a search engine like Bankrate.com and screen the 5 to 10 cheapest (highest paying) CDs out there. Today, three-month federally-insured CDs pay up to .85%. (Just don't put more than $250,000 in any single name, since that's the most the FDIC will insure per bank per taxpayer.)
Bank Deposit Brokerage Accounts
Wealth management firms, including brokerage firms, often offer access to insured deposits through "bank deposit accounts," where they sweep customer cash in $250,000 chunks into one or more affiliated or third-party banks. These programs offer two benefits: First, it's sometimes possible to get FDIC-insurance coverage up to $1.5 million in cash through a single portal... which certainly has convenience value. Second, these programs tend to pay more for cash deposits of over $1 million than they do for small deposits.
Money Market Funds
Size is also something that can be leveraged at money market funds, where having more than $1 million can get you access to institutional share classes. Today, institutional funds can pay .25% or more in yield than do retail funds used by individual savers. Stick with so called "prime funds." They're highly regulated, highly liquid and highly diversified thanks to new rules put into place after the financial crisis, and will generally track Fed Funds rate increases more quickly than will all-government money market funds.
If you feel you're savvy enough to invest in individual securities in the open market, opportunities currently exist in notes issued by state and local governments. Right now they're paying about as much as US government and agency notes -- the benefit being you don't have to pay federal (and in some cases state) income taxes on the interest.
Also, don't be afraid to extend maturities out to as much as a year -- as long as you don't anticipate using the money for a while. The difference between securities maturing in 30 days and securities maturing in a year is as much as .50%. Professionals call this "playing the roll" or "rolling down the yield curve." A one-year note gets shorter with each passing day. Six months from now it will be a six-month note. Nine months from now it will be a three-month note. The shorter the maturity, the less price risk there is. Which means the passage of time insures you against interest rate increases, while in the meantime you're getting rewarded with a higher return.
Cash has been a dead asset for most investors for the last seven years. But with the latest rate increase by the Fed, that's about to change. Good news for those investors willing to invest a little more time managing their cash.